Educational Articles

Master Limited Partnerships – a Primer

Sigourney B. Romaine, CFA
| October 28, 2010

Master limited partnerships were established by the tax act of 1986 to permit investors to earn high, tax-deferred cash returns through investments in specified assets. There are many types of MLPs now, including coal, shipping, amusement parks, and timber, but the largest sub-set of MLPs comprises companies that produce, process, transport, and store oil and natural gas products. In the Alerian MLP Index (AMZ), a composite of 50 of the largest energy MLPs, petroleum and refined product transport accounts for 38% of the total market capitalization, followed by natural gas pipelines, 33%, and smaller shares devoted to gas gathering and processing, exploration and production, propane distribution and shipping. The five biggest MLPs in Value Line’s Pipeline MLP industry are the five largest in the Alerian index, too: Enterprise Products Partners (EPD), Kinder Morgan Energy Partners (KMP), Plains All American Pipeline (PAA), Energy Transfer Partners (ETP), and Magellan Midstream Partners (MMP).

As income vehicles, MLPs compete with real estate investment trusts, high-yielding stocks, and bonds. The Alerian index is currently yielding about 6.3%, down from over 8% in October 2009, as the index’s components have rallied strongly since that time. (The average REIT yields around 4.5% now.) Most of the unit price gains have been due to declining interest rates, since cash distributions are up only 5% to 6% in the last year. At a yield spread of just 230 basis points over the long Treasury bond, partnerships face a double danger: that interest rates will eventually rise, reducing unit values, and that the market may demand a wider spread over the Treasury yield. With the economy growing more slowly now, however, we don’t think either will happen in the next few quarters.

Most MLPs derive a majority of their income from fixed fees for transportation or other services. But most also have some exposure to volatile commodity prices. Most interstate oil and natural transportation has highly predictable revenues, as the companies do not build new pipelines without long-term contracts covering nearly all of the new line’s capacity. But intrastate business is trickier. There, the MLPs have to take commodity risk because competitive conditions force them to offer keep-whole or percent-of-proceeds contracts under which, essentially, the MLP is paid partially in kind. Too, some of the partnerships also produce oil and gas. These factors account for some of the earnings volatility you’ll see on the Value Line pages covering such partnerships.

MLPs have two kinds of partners: limited partners, who have no say in company policy; and the general partner, which manages the company. Typically, the general partner receives 2% of distributable cash flow, plus incentive distribution rights (IDRs) once limited partner cash distributions exceed a certain level per quarter. Most MLPs are now distributing enough cash to limited partners; such that the general partner gets about 50% of any increases in cash distributions. Distributable cash flow is roughly net income plus depreciation, plus/minus other noncash expenses/revenues; most partnerships pay out a high proportion of distributable cash flow, but all are allowed to retain considerable cash to invest, at the sole discretion of the general partner.

Investors should remember that units of limited partnership interest are not shares of stock in corporations. The tax law considers limited partners to be owners of the partnership’s assets. As such, they are taxed on their proportionate shares of the partnership’s taxable income, calculated according to IRS rules, not generally accepted accounting principles. Cash distributions are irrelevant to a partner’s income tax liability and are usually several times as high as a partner’s taxable income in the first year of ownership. Distributions, however, are important to a limited partner’s tax liability when he or she sells the units; distributions decrease the units’ tax cost base, while reported taxable income per unit increases it. After several years, the adjusted cost will usually be over 10% below what a limited partner paid for the units, increasing capital gains taxes or reducing the taxable loss. Therefore, even though a limited partner pays no income tax on cash distributions received, income taxes on a profitable unit sale will be higher than for a common or preferred stock.

The difficulties of investing in MLPs are not limited to tax calculation when a partner sells. Partners must include an extra form with their form 1040 to show income or loss from partnership investments. And a partnership investment can entail filing extra state income tax forms, too.

Despite the tax issues posed by MLPs, we think investors targeting income and growth should seriously consider them. The prospects for natural gas in the United States look much better now than just a few years ago, since gas producers can now develop the Marcellus, Eagle Ford, and other good-sized shale deposits profitably, even with natural gas priced at around $4 per thousand cubic feet. Getting gas from these and other prospective areas to market will require new pipes, and the MLPs will build and profit from the investments. That should keep cash distributions growing at perhaps 5%, on average, for the group. Total returns will not likely approach the giddy heights the industry has achieved since 1995, but the MLP’s are now yielding well over twice what the average stock pays.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.